Some thoughts on ROCE

Thanks to Twitter, I bacame aware of a thought-provoking FT article by Terry Smith on returns on capital. In summary:

The problem is that while fund managers who buy these low-return companies wait for the events which they think will change the situation, the companies destroy value. But the reverse is true when you own shares in a company that generates returns well above its cost of capital.

So, ideally investors should look for companies with high ROCE and low cost of capital.

But I think there is a snag here. Investors are the ones who provide equity. If you want to know the cost of equity, look at the earnings yield (reciprocal of PE). What’s good for the company is what’s bad for the investor. If the company has cheap access to equity, then it means that I, as an investor, am willing to provide it, with a low return to myself. From my perspective, I want to provide equity when its cost is high, not low.

So what I’m looking for as an investor is a company that has a high ROCE, and high earnings yield. Did someone just say “Magic Formula”?

As an aside, it is interesting to see that although interest rates are low, companies have had problems actually accessing debt due to banking woes. This might explain two things: if debt finance is difficult to obtain, then companies must resort to equity finance. This pushes up the price of equity finance – hence why we have rising stock markets. The second thing it explains is why companies are stockpiling cash: debt is difficult to obtain, equity cost is high, so companies must build up reserves in order to finance expansion.

It’s also interesting to ask: what would be the effect of more levies on bank balances? From an investor’s point-of-view, funds would flow out of banks and into something else. One place would be equities. So share prices would increase. Concomitantly, companies will reduce their bank balances too, because the cost of cash (wow, we’re now entering a whole new paradigm where not only does debt have a cost, but cash does too) – and that’s OK because the increase in share prices means that it’s cheaper to raise equity finance. It does make banks rather illiquid, mind.

So, if you believe that argument – I thought of it, so you probably shouldn’t – then actually this whole Cyrpus thing is bullish for markets, not bearish. It’s probably really good too for mezzanine finance. In fact – and this one is not really a new idea by me – we could see the emergence of a whole new subsector in finance, where companies provide a substitute for banks.

OK, leaving those things aside and returning to the original point … there’s probably a more subtle interplay of ROCE and cost of capital, involving both the availability and cost of both of the components of equity and debt. It’s also not just about high ROCE, it’s about incremental ROCE. A company might have high ROCE, but if it can’t find any worthwhile projects to invest in, what benefit does it do me as an investor even if I can provide equity?

This leads us on to the next topic as to why Greenblatt chose tangible capital as a way of measuring returns. Although I have reservations about it, my understanding of his logic is that it is a way, albeit imperfect, of measuring a potential return on incremental capital.

I’m sure I’m missing out on a ton of other point, too, but that will do for now.

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About mcturra2000

Computer programmer living in Scotland.
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